The march is on: Canada, the European Central Bank, Sweden and Switzerland (2x) have all cut base rates, with more cuts expected before year-end. Still, we believe this is unlikely to mark the true ‘beginning of the end’ for high base rates. Inflation remains sticky as borrowers continue to face headwinds. Add to that, the U.S. Federal Reserve is unlikely to cut aggressively, which will make it harder for other countries to cut repeatedly given the U.S. economy’s anchoring effect on global markets. “Slightly less high for longer” seems to be the view for now…unless something breaks.
Election results are rolling through globally, including plenty of surprises across the European Union, France, India, Mexico and others. The general trend toward more nationalistic policies—including in-sourcing, lower immigration and tariffs—is unlikely to help bring down inflation in the medium-term. Nonetheless, global equity markets have largely brushed them off and hit a number of record highs in recent weeks. At the same time, M&A activity is finally picking up after the quietest period in a decade. As we’ve seen previously, the U.S. and E.U. have led the rest of the world in the pick-up in activity, and Asia is beginning to follow suit.
Global M&A and Leverage Finance Issuance
In recent months there has been much debate on: (i) relative value across geographies and asset classes; (ii) the impact of high base rates on yields; and (iii) the compression in the spread of floating rate debt instruments globally. How does the impact of these factors differ from previous cycles? Based on the CS Leverage Loan Index over the last 30 years, the market is clearly suffering from recency bias. In fact, current spreads as a percentage of total yield are actually just above the historical average (56th percentile) and remain wider than similar periods in the 1990s and in the lead up to the Global Financial Crisis. However, there are limitations to the read across, as credit quality and documentation are not like-for-like over the last 30 years, given single B-rated risk is now a larger proportion of the index relative to more highly rated BB risk. As a result, asset selection and assessment of risk/return will continue to determine which credit investors are successful.
CS Leverage Loan Index 3-Year Yield
U.S.
The U.S. macroeconomic picture continues to signal some moderate slowdown, with a particular focus on the leading job indicators signaling a slowdown in the jobs market and inflation breaking its higher first quarter trend. The market continues to be ahead of the U.S. Federal Reserve in predicting almost two cuts in 2024 as opposed to one, but that is likely of minimal consequence as both are signaling a modest slowdown by year-end. Broader activity has shifted from being almost exclusively refinancings and/or repricings to new money deal activity in the last couple of months, which we think is likely to continue. Given the tighter spread backdrop, credit managers are also preparing for a potential spread widening event.
Europe
The European political environment has captured global headlines, but the impact has largely been felt in the equity markets while credit has remained unaffected for the most part. On the M&A front, activity has picked up since the end of the first quarter, and attractive cross-border relative value has been selectively available on a spread basis. That increased activity is expected to be supported by the backdrop of further rate cuts by the European Central Bank and the Bank of England in the future. However, given wage inflation pressures on the services side, the U.K. most likely has limited ability for multiple cuts at the moment.
APAC
Japan, India and Australia/New Zealand saw outsized activity for the quarter. Japan continues its recent surge in M&A, in particular for sponsor-backed opportunities, but those volumes are still largely funded by traditional bank lenders. Notably, given the increase in size of the deals, the large banks are reaching concentration limits. This is allowing other credit providers to get in on the action – a view that was recently supported by the Japanese Ministry of Finance. In India, despite a surprising election outcome, equity and debt markets set new records. A strong outlook for credit activity is expected in the second half of the year, including great potential sponsor exits and buyouts. Australia has seen a pick-up in activity in both M&A and refinancings in the last couple of months after a quieter start to the year, but inflation is sticky, creating a risk of further interest rate hikes before year end. Across Asia, they’ve experienced spread compression, which has been most acute for the largest sponsor buyouts and has varied somewhat by region.
Conclusion
The focus on inflation outlook and what that means for base rates globally will continue to drive credit markets. The market is likely to be data dependent by country and via an interconnected global web for the next three to six months, at a minimum. “Slightly less high for longer” rates will continue to test companies and consumers, despite somewhat lower or more ‘normalized’ spreads, with more borrowers likely to face issues as rates remain elevated. The ever-impending M&A wave of the last 12 or so months seems to finally be arriving, but just because deals are announced doesn’t mean they will necessarily close and fund.